The EU’s Trading Ban in Sovereign CDS

A Signal Loses Its Significance

As a friend recently reminded us, the charts of credit default swaps (CDS) on sovereign debt in the euro area that we are regularly updating in these pages may no longer be indicative of the underlying reality of market perceptions.

This is so because the EU's bureaucrats, in their ongoing attempts to manipulate markets, have issued a ban on so-called 'naked' trading in CDS. This means that speculators are no longer allowed to buy and sell CDS contracts to merely express their opinion. Unless one holds the underlying bonds, one will no longer be allowed to trade these credit instruments from November 1 onward.

Instead, trading in them now takes place only 'by appointment', as every trade must be sanctioned by the EU's bureaucrats. A buyer or seller of CDS must now be able to “prove that a CDS position is a hedge, showing correlations (both quantitative and qualitative)”.

Not surprisingly, liquidity in the CDS markets is evaporating as a result of these new regulations and we can probably no longer rely on these markets to give us relevant signals (we will however continue to keep an eye on them to see what develops).

5 year CDS on the sovereign debt of Portugal, Italy, Greece and Spain – with hedge funds no longer able to trade these instruments unless they hold the underlying bonds, liquidity in these markets is drying up and the quality of their price signals comes into doubt.

To this it should be noted that the EU's politicians and bureaucrats fundamentally misconceive what the role of speculators in the market economy is. They assume that speculation in financial assets is 'bad' a priori, and that it 'adds no value' to the economy. In the case of CDS contracts on sovereign debt, speculators are painted as evil toads preying on innocent deficit spending governments and interfering with their god-given right to saddle future generations with mountains of debt that can never be repaid.

Similar sentiments are regularly expressed when energy or food prices increase sharply: it is allegedly the 'fault' of speculators in the futures markets that these things happen.

However, this is simply not true. First of all, every entrepreneurial activity is essentially 'speculation'. It matters not whether one buys a stock, a commodity or a CDS contract, or whether one inaugurates a line of production. In all these cases one must make an assessment of future conditions. If this assessment is correct, one will reap a profit, if it is incorrect, one will suffer a loss.

A manufacturer who decides to begin production of a consumer good X today, employing the factors A, B, C and D to do so, must make a correct guess as to the price he can charge for consumer good X at the time the production process is finished and the goods can be shipped and sold. Unless the selling price exceeds what he must pay today for the factors used in their production, he will make a loss. Obviously then, he 'speculates' on a certain configuration of future market conditions.

But what about speculators in financial markets? It is important to keep in mind that the economy is in an unceasing process of trying to move to a state of 'equilibrium' – a state where no further change is possible and essentially all entrepreneurial profit disappears. However, this state can never be reached – in the real world, the economy is changing without cease, the market data are constantly adapted to changes in people's value scales and perceptions. The role of speculators is to speed up this process of adaptation. By anticipating future changes in market conditions and hence prices, speculators bring these changes about more quickly than would otherwise be the case. This sends important price signals to all other actors in the market economy, who will alter their conduct accordingly. To the extent that speculators err about future conditions, the effects of their actions will be self-correcting. 'Speculative excess' in prices is never sustainable for long, as it will not be supported by the real world supply-demand situation.

Prices are the means by which the economy achieves coordination, they are what makes the market economy work so smoothly in spite of the seeming 'anarchy of production' that has long been bemoaned by socialists and planners as somehow ineffective and wasteful. Given the complexity of the economy and the wide dispersal of knowledge, it is literally impossible for a central planning authority to achieve such coordination. It is the price system that creates what Hayek called the 'spontaneous order' of the market economy. It follows from this that the faster prices are adjusted to changing conditions, the better, as the important information they convey reaches economic actors more quickly.

Speculators in financial markets are therefore indispensable to the smooth functioning of the market economy. Denying them access to trading certain financial instruments as the EU is now doing merely leads to a less efficient economy, as resource allocation becomes sub-optimal.

'Unintended' Consequences

Not surprisingly, the 'unintended consequences' of this policy are already in evidence. For example, the Markit SovX index, which we have regularly updated here, has essentially become useless as a gauge of European credit stress for investors.

“An index once used as a key barometer of Europe’s debt-market stresses is set to be stripped of its remaining relevance as impending new regulation will make it harder to trade.

Trading volumes in the iTraxx SovX Western Europe index — which tracks the cost of insuring against government bond defaults in 14 European countries — have shrunk to zero, building on the collapse witnessed throughout 2012, figures from data provider Markit showed Friday.

New European regulation due to come into force Nov. 1 will ban traders and investors from buying sovereign default-insurance contracts against government debt they don’t own, in turn making it against the rules for investors to purchase the SovX unless they own underlying bonds from each country.

This will further hinder the usefulness of the SovX for investors, who increasingly have found little reason to buy an index representing a basket of countries ranging from those at the center of the debt crisis, such as Spain and Italy, to ones that don’t even use the euro, such as Norway. This is a turnaround from just last year, when the SovX was still viewed as an accurate gauge for the European debt crisis.

[...]

New European Union rules will ban so-called “naked short-selling” of sovereign credit default swaps, or CDS, which pay cash to holders in case of a default. The rules are designed to reduce what is seen as a destabilizing, speculative activity.

It means that unless an investor holds corresponding, positive positions in all 14 countries included in the SovX, buying the index would constitute holding a short position, in breach of the rules.

“If the position is held in sovereign debt of only one or several euro-zone member states, buying SovX to hedge this position would unavoidably lead to acquiring uncovered CDS positions in those sovereigns for which one does not have position in bonds,” said a spokesman at The European Securities and Markets Authority, which oversees the regulation passed by the European Commission.

Markit conducted its semi-annual reshuffle of SovX constituents last week, this time removing less-liquid Cyprus. Since then, the index hasn’t traded at all, data from Markit show.

(emphasis added)

We have put the word 'unintended' in quotes above, because some of these consequences are actually not unintended. The EU's bureaucrats and politicians want to destroy the CDS market, precisely because they do not want investors to have a reliable gauge of sovereign credit stress in the euro area. The idea is that in the absence of a reliable signal, investors will be less inclined to put pressure on the bonds of governments in fiscal trouble.

This idea is erroneous. The main effect will be to make investors loath to hold such bonds at all, since hedging them has become inefficient – in fact, it has become nigh impossible, given that there are e.g. no longer any trades whatsoever in the SovX (a similar fate likely awaits CDS on the debt of individual countries). The European government bond markets are based on ever more coercion instead of the free choices of the investing public (we have recently written about how pension funds are forced to buy government debt due to yet another batch of new regulations).

As the WSJ reported in another article on the topic of the CDS trading ban:

“Hedge funds have a significant presence trading CDS in these emerging markets, in what are known as ‘directional trades.’ If they think the economic climate will deteriorate they buy CDS. They sell if they think those economies will do well. And they do it without necessarily owning the underlying bonds.

Some would call this dastardly speculation. But it also keeps the CDS market liquid. And liquid CDS markets help to keep underlying bond markets steady.

Regardless, it will be banned from Nov. 1 for accounts that don’t already hold the bonds. Some market-watchers believe this could discourage investors from buying the bonds. Why buy them if it’s hard to hedge the risks?

Hedging by using indexes won’t work either. The iTraxx CEEMEA index of 17 emerging market countries has done this and worked well in the past. But the index also includes five EU member countries, which are subject to the regulation. Under the “no naked shorts” rule, they will be off-limits for investors who don’t hold all five of the relevant underlying bonds. Unless this index is rejigged, the idea using it for hedging bond exposure is a no-go.”

(emphasis added)

Making it difficult to insure exposure to government debt of course does absolutely nothing to address the underlying problems. It is merely a futile attempt to obscure these problems, by falsely blaming speculators for the results of the irresponsible fiscal policies of European governments.

As far as we are aware the trading ban only concerns CDS contracts on sovereigns, so our bank CDS index will remain relevant. Given the myriad ways in which the fate of governments and banks is intertwined these days, it may therefore serve as a reasonable proxy should trading in sovereign CDS in the EU cease altogether (which unfortunately seems highly likely).

We plan to continue to update the data on sovereign CDS as well for the time being though, unless or until we become convinced that it no longer makes any sense to do so at all. However, we caution readers to henceforth regard these data with the appropriate degree of circumspection.